Monday, December 22nd, 2014

FACTSHEET: Financial regulation explained

Democratic senators discuss financial regulation. From left, Sen. Sherrod Brown of Ohio, Sen. Chris Dodd of Connecticut, Sen. Harry Reid of Nevada.
Democratic senators discuss financial regulation. From left, Sen. Sherrod Brown of Ohio, Sen. Chris Dodd of Connecticut, Sen. Harry Reid of Nevada.

Are you a Wall Street banker, a captain of industry, a financier? If not, then maybe you've thought once or twice about buying a credit default swap or a collateralized debt obligation. No? Well, maybe you've asked a private equity company to help you hedge your risks through ...

Okay, Okay, we'll stop now.

If you don't fit into any of the above categories, there's only one piece of the massive financial reform bill Congress is considering that would directly affect you -- the proposed consumer protection bureau. It's supposed to help consumers make sense of their mortgages, credit cards and other financial matters, so big companies can't overwhelm them with pages of fine-print agreements.

After that, the bill goes into the deep weeds of esoteric high finance. More than a year and a half after the height of the financial crisis, Congress is trying to pass some regulations to prevent a repeat of the worst economic downturn since the Great Depression.

What's in the Dodd bill

For the purposes of this factsheet, we're focusing on the legislation put forward by Democrats in the Senate, shepherded by Sen. Christopher Dodd, D-Conn. It's 1,400 pages of new rules that change the way the financial system is regulated. The House passed its version of financial reform in December 2009 that differs on some details. But because the Senate is slow-moving and prone to requiring 60 votes for action, it seems likely the Senate bill will be a baseline for negotiations. Keep in mind this bill is a moving target. It will be amended before passage, and the Senate and House will then have to negotiate their differences before a final vote.

Here are the bill's main components:

Consumer protection. This bureau's mission would be to help people looking for mortgages, credit cards and other financial products to avoid unfair, deceptive or abusive practices. In the Senate version, the new consumer protection bureau would be housed within the Federal Reserve, though it would have its own budget. The House version of the bill creates a standalone agency.

Policing "systemic" threats. The bill creates a Financial Stability Oversight Council to look for overarching threats to the financial system and to recommend specific steps to rein in large financial companies when necessary. The Federal Reserve would be given new powers to regulate nonbank financial companies. A new Office of Financial Research within the Treasury Department would collect financial data and conduct research and analysis.

"Orderly liquidation authority." This part of the bill sets up a panel of three bankruptcy judges who convene and decide, within 24 hours, if a large financial company is insolvent. If a big firm is teetering on collapse, the Treasury Department, the Federal Deposit Insurance Corp. and the Federal Reserve would have to agree to liquidate it, using a special fund created with payments from the largest financial firms. The legislative language says the fund must be used to dissolve failing firms. To pay for the shutdowns, the FDIC would set fees on the financial companies based on their size, raising $50 billion. The fund has become a point of controversy in recent weeks. Opponents have said it means guaranteed bailouts, a claim we ruled False, and some Republicans want the fund removed from the final bill.

The "Volcker Rule." This rule would prohibit banks from engaging in proprietary trading, which is trading the bank's money to turn a profit. Advocates for this rule say these kinds of trades tend to put banks into a conflict of interest with their customers. The rules also would limit banks' relationships with hedge funds and private equity funds. Nonbank financial institutions also would see new restrictions.

Derivatives. Most but not all derivatives would be traded on an exchange. A derivative is an investment usually based on some outside event. Here's an example of a good derivative: Southwest Airlines has to buy jet fuel over the coming year to run its planes. If oil prices skyrocket, Southwest loses money. So the airline invests money in something that will pay out if oil prices increase, lowering its potential for losses.
But derivatives have a dark side: During the financial crisis, derivatives exacerbated losses, especially in the housing market, and investors weren't sure who was taking the biggest losses. The new regulations are aimed at making clear who is trading in derivatives. A version of derivatives legislation sponsored by Sen. Blanche Lincoln, D-Ark., is considered particularly strict.

Hedge funds. Generally speaking, hedge funds are investment vehicles for selected groups of elite investors. The name comes from hedge funds' tendency to be very careful about managing, or hedging, risk. This means they often buy derivatives or other unusual types of investments. Under the new regulations, large hedge funds would have to register with the Securities and Exchange Commission and report their activities. Some exemptions are provided for venture capital funds and private equity fund advisers.

"Say on pay." Shareholders of publicly traded companies get to vote on executive pay, though the vote is nonbinding. Translation: The company can choose to disregard the shareholders' vote. (Yes, this doesn't seem like much of a say to us. But experts tell us it's actually progress in the longstanding fight to give shareholders more of a voice in corporate governance.)

Credit ratings agencies. The credit ratings agencies are the people who said, before the financial crisis hit, that securities built from subprime mortgages could be great investments. Wrong, wrong, wrong. The bill creates an Office of Credit Rating Agencies and puts in place rules for internal controls, independence, transparency and penalties for poor performance.

Concerns and criticisms

Here are some of the main points of concern raised about the proposal:

"Too big to fail is too big to exist." Some economists argue that the idea of resolution authority for large firms is misguided. The large financial firms that pose "systemic" risk cannot be shut down without harming the broader economy, they say, and the big players should be broken up. This issue divides experts who otherwise agree on the need for increased regulation. People like Paul Volcker, the former head of the Federal Reserve, and Simon Johnson, former chief economist of the International Monetary Fund, urge measures that would limit the size of the biggest banks. Democratic senators Ted Kaufman of Delaware and Sherrod Brown of Ohio also support limits. Meanwhile, people like Dodd, and Paul Krugman, the Nobel Prize-winning New York Times columnist, say that breaking up the banks isn't necessary to avert the next meltdown.

"To be determined" regulations. Some important restrictions are not detailed in the bill. Instead, the bill says that officials will study and develop regulations on a particular issue. That creates a lot of unknowns about how effective the bill will be. The rules on credit rating agencies are particularly vague. Lawrence White, a professor of economics at New York University, says he is concerned that the yet-to-be-determined rules could discourage new firms from getting into the credit ratings business. "The grand irony of this approach is that we will end up making the current incumbents more important, not less important," he says.

The autonomy and authority of the consumer protection agency. Republicans have voiced concerns that the consumer protection agency will be too intrusive, regulating everyday companies that aren't really part of the financial industry. Democrats, meanwhile, are debating how much independence to give the new agency. Consumer advocates say a stand-alone entity, as proposed by the House, would have more teeth.

Fannie and Freddie? Fannie and Freddie who? Please tell us you haven't forgotten about Fannie Mae and Freddie Mac. These are the two government-created companies that back many mortgages. They were supposedly private companies but often thought of as public. Then the financial crisis happened, and the Federal Housing Finance Agency placed them in conservatorship because they were out of money. The federal government now is likely on the hook for huge losses sustained by Fannie and Freddie when the housing bubble popped. The current bill doesn't address Fannie and Freddie's losses in any significant way. Experts we spoke with say losses could be anywhere from $200 billion to $400 billion, and the government will have to make good on that eventually. A Republican alternative makes a case for a special inspector general and limits on bailouts.